With more than 35 years of experience as an attorney and financial planner, I’ve worked with hundreds of business owners to solve problems, help them exit their businesses or retain their top talent. I’ve worked all over the country with financial advisors and business owners to help them better prepare for their financial future. My Forbes.com blog is focused on financial intelligence for business owners. I talk about current events, experiences I've had with business owners and a lot about taxes. Steve is a retired employee of the Principal Financial Group®, continuing to serve the company as an independent consultant writing and speaking about financial topics for business owners. Steve is also an adjunct professor at Drake University. The subject matter in this communication is provided with the understanding that neither Steve Parrish nor The Principal® are rendering legal, accounting, or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements. Parrish does not provide legal services on behalf of the companies of the Principal Financial Group. Insurance products from the Principal Financial Group® are issued by Principal National Life Insurance Co. (except in NY) and Principal Life Insurance Co., Des Moines, IA. Securities offered through Princor Financial Services Corp., Member SIPC, Des Moines, IA.

Save Executive Taxes Using Executive Benefits

Four words: “I told you so!” I’ve wanted to use that annoying phrase in the last few weeks. Even though income taxes went up more than a year ago, and we as advisors were screaming about it almost immediately, I’m finding that a lot of highly compensated taxpayers are just now getting the message. They’ve met with their tax preparers and are returning home looking like they received a bad diagnosis from their doctors.

Taxes are up, so you have your executives’ attention. If you’re an employer and are seeing these glum reactions from your best and brightest employees, you should consider helping them as soon as possible. A discouraged executive is a non-productive executive.

How can you help? You can provide executive benefit plans that help lower their tax exposure. Now is the time to initiate long-term benefit plans that: 1) encourage desired performance, 2) provide a golden handcuff for the business and 3) incentivize your top talent. Need some ideas? Following are some tax-advantaged plans for executive benefits.

Stock Options: Stock options are tax-advantaged because no tax occurs until the option is exercised. Be sure the executive is informed of two commonly misunderstood aspects of stock options: 1) the employee must come up with the money to exercise the option in order to harvest any gain, and 2) the gain on a nonqualified stock option is taxed as ordinary income, not capital gain. Also, consider the potential disadvantages of stock options to the owner of a privately held business.

Restricted Stock: Because stock options must now be reflected as a liability on the company’s books, restricted stock has recently become more popular as an executive benefit. Company stock is issued with a risk of forfeiture (e.g., continued employment with the company) that expires after a period of years. This benefit is a golden handcuff for the executive, motivates him or her to add to the stock value and defers taxation until the risk of forfeiture lapses. It should be kept in mind, however, that this benefit also deprives the executive of the ability to manage to both stock price and taxes. When the stock restrictions cease, the stock is taxed even if that’s not to the executive’s benefit.

Nonqualified Deferred Compensation: This benefit has seen a resurgence in interest as the economy improves and taxes on the affluent increase. Deferred compensation plans can allow an executive to defer income that otherwise would be taxed at current, high tax rates, and then receive that income at a future date when the employee’s tax rate is potentially lower. In other cases, the plan is designed to have the employer bonus corporate money into a deferred compensation account in lieu of an additional cash bonus. The employer can then base the growth in that account on company defined performance standards (i.e. profit, sales, etc.). Since nonqualified deferred compensation plans are based on the company’s promise to pay, it is advisable that these plans be informally funded with some kind of long-term asset, such as life insurance or mutual funds.

Tax-favored Insurance Benefit Plans: Risk-based products such as life insurance, disability income insurance and long-term care insurance have a favorable tax status. An employer can, for example, supplement the company’s long-term disability plan by adding an individual disability income insurance policy for executives. If you do this, and structure it as a Qualified Sick Pay Plan, the additional premium would not result in added tax to the executive. Utilizing these insurance plans, the employer helps the executive with both insurance planning needs and saving taxes.

“Grossed-up” Benefits: A comparatively easy way to incentivize an executive is to not only provide a benefit, but pay the executive’s tax on that benefit. This is often referred to as “grossing up” the benefit. The formula is to have the employer pay: 1 divided by (1 minus the executive’s tax bracket). Take the example of a cash value life insurance policy provided a top employee as a form of an ongoing executive bonus. If the annual premium is $20,000 and the employee’s marginal tax bracket is 33%, the employer would pay the executive $29,851. This would provide the cash flow for the premium, the executive’s tax on the bonus and the tax on the tax. The net result is the executive would have a zero after-tax cost; and, since the bonus is deductible to the company, the after-tax cost to the employer is $19,403 (assuming a 35% corporate tax bracket).

It’s not always easy to capture a busy executive’s attention. In the midst of this tax season, however, high wage earners are focused on the IRS 1040s their tax preparers just provided. The sticker shock of increased taxes is setting in. Now is the opportunity for employers to do more than commiserate with their top talent. They can both provide a tax efficient way to ease the executive’s increased costs and secure a great retention tool. Win-win.

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